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The Efficiency of the Chinese Stock Markets:
Some Unfinished Business on the Road
to Economic Transformation
by
Burton G. MalkielPrinceton University
CEPS Working Paper No. 154December 2007
Acknowledgements: I am indebted to Gregory Chow for extremely helpful comments and to Rui
Yang in helping to obtain some of the data included in this paper. I am also grateful to the Center
for Economic Policy Studies for supporting my research in this area.
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12/20/2007
The Efficiency of the Chinese Stock Markets:
Some Unfinished Business on the Road to Economic Transformation
Burton G. Malkiel*
Princeton University
In his William S. Vickrey address to the International Atlantic Economic
association in 2005, Franklin Allen examined the question of how China has managed to
grow rapidly in the absence of many of the factors usually considered essential to
economic expansion in Western economies. China had no tradition of the rule of law,
corruption was rampant, and the financial institutions that could facilitate growth were
inadequate and/or dysfunctional. In particular, the stock and bond markets in China were
undeveloped and the banking system did not serve as an institution that could effectively
channel individual savings into those companies with the highest potential investment
opportunities.
Conventional Western wisdom normally suggests that economic growth requires
a well functioning financial system, supported by a strong legal system and by proper
corporate governance. As Allen argued, however, China possessed none of the above.
The stock market was undeveloped and did not serve as an important source of business
financing. The banking system appeared dysfunctional. Little credit was offered to the
private sector, and there were large nonperforming loans to inefficient state-owned
enterprises.
* I am indebted to Gregory Chow for extremely helpful comments and to Rui Yang in helping to obtainsome of the data included in this paper.
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How, then, did China manage to achieve real growth rates close to ten percent
during the period from the late 1980s through 2005? Allens explanation was that China
relied on non-standard and non-Western financing channels and governance mechanisms
that were uniquely Chinese. Self-fundraising provided a large fraction of the total capital
needs of private firms as well as state or quasi-state owned companies. Seed finance was
often obtained from (extended) family and friends, from foreign direct investment in
enterprises, and even from illegal activities. According to Allen, Qian and Qian (2007),
self-fundraising far exceeded domestic bank financing for private Chinese firms, and
equity and bond issuance accounted for only a tiny fraction of the funds raised, at least
through 2005. Even for state-owned enterprises, self-fundraising accounted for about
half of total funds raised.
This paper describes the striking changes in Chinas financial markets since 2005.
After noting changes in the banking system, it focuses on the remarkable growth in the
Chinese stock markets. While there has been significant progress, the local stock markets
appear still to be relatively inefficient, and the banking system has much further to go if
China is to continue its transformation to a market economy. The concluding section of
the paper, addresses suggested further changes in the financial system that should
facilitate continued rapid growth for the Chinese economy.
The Growth of the Chinese Stock Markets
When Allen addressed these meetings in 2005, the capitalization of all the shares
traded on the Shanghai and Shenzhen stock exchanges was very small relative to Chinas
GDP and the capital markets of Western economies. The total capitalization of the entire
Chinese stock market was less than that of General Electric, Exxon-Mobil, and AT&T in
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the United States. Allen was certainly correct in concluding that the public stock markets
played an insignificant role in the financing of Chinese businesses.
Over the next two years, however, the market capitalization of the Chinese stock
markets increased significantly due partly to a sharp rise in stock valuations, and partly
to increased share issuance for new capital from private as well as state-owned
enterprises.
It is important to understand that there is literally an alphabet soup of different
kinds of Chinese shares. Here we will concentrate on three of the most important
categories. So-called A shares are available for purchase by Chinese nationals, but
only to a very limited extent by foreign nationals who have acquired a QFII (Qualified
Foreign Institutional Investor) quota. Thus, the A-share market has been essentially
closed off to foreign investors and prices are largely determined by the actions of
individual Chinese investors. A shares are traded on the Shanghai and Shenzhen stock
exchanges. So-called H shares are the stocks of Chinese companies that list on the
Hong Kong Stock Exchange and agree to present their accounting statements in
accordance with international accounting standards. These shares are available to the
international investing community. Another category is called N shares that trade (in
New York) on either the New York Stock Exchange or the NASDAQ market. Other
smaller share types are L shares traded on the London Stock Exchange, S shares
traded on the Singapore Stock Exchange, etc. While the Chinese have loosened
restrictions to some extent, there is only limited opportunity for Chinese nationals to
invest in foreign markets and for international investors to transact in the A-share
markets.
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It appears that the financing of Chinese firms has changed significantly since
2005 and that stock markets have begun to play a meaningful role in corporate finance
and in the allocation of capital. During 2006 and 2007 there has been remarkable growth
in the Chinese equity markets. The total capitalization of all Chinese equities traded on
the Shanghai and Shenzhen stock exchanges (including shares held by the government)
grew from about $1 trillion at the end of 2005 to almost $3 trillion in August 2007, as is
shown in Exhibit 1. The Exhibit also shows a sharp rise in the number of listed
companies. In addition over $1 trillion of Chinese company shares were traded on the
Hong Kong Stock Exchange, as is shown in Exhibit 2. While the domestic stock market
has traditionally been a very small source of financing the growth of Chinese firms, new
issue activity was substantial in 2006 and 2007. Exhibit 3 displays a more than tripling
of activity in the market for initial public offerings (IPOs). Indeed, China became the
biggest capital raiser in 2007, with over USD $60 billion in new listings expected. New
listings include the sale of shares in Chinas major government-owned commercial banks.
We will need to ask however, how efficiently the stock market performs its role.
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Exhibit1
Exhibit 2
Total Market Capitalization of Chinese Companies
Traded on the Hong Kong Stock Exchange
0
200
400
600
800
1,000
1,200
12/1/2001
6/1/2002
12/1/2002
6/1/2003
12/1/2003
6/1/2004
12/1/2004
6/1/2005
12/1/2005
6/1/2006
12/1/2006
6/1/2007
Date
MarketCapitalization(USDbillion
Market Cap
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Exhibit 3
TotalIPOFundsRaisedForChineseCompanies
0
10
20
30
40
50
60
70
2001 2002 2003 2004 2005 2006 2007
Year
EquityFundsRaised
(USD
billions)
IPO
E
Changes in the Banking System
As Allen noted, the banking system in China has long been devoted to channeling
funds to favored SOEs, rather than to users who might make more productive use of the
funds. As a result, the major Chinese commercial banks accumulated a mountain of non-
performing loans (NPLs). Since China was required to open its banking system to
foreign competition as a condition for its membership in the World Trade Organization,
the government understood that two reforms were urgently required: 1) the banks would
need to clean up their balance sheets and remove substantial amounts of NPLs, and 2) the
banks would need to find new sources of capital funds and thus would need to move
toward a system where all the shares of bank stock would become fully tradable and
distributed to the public.
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To these ends, the government created and funded special asset management companies
to take over many of the NPLs from the banks. Moreover, the government allowed the
major commercial banks to go public and raise substantial amounts of capital from
private investors. In addition, the government pledged to make all the government-
owned shares of these banks tradable and planned to have them gradually released into
the market over time. As a result, the proportion of total loans represented by NPLs
declined sharply for the four largest commercial banks in China, as is shown in Table 1.
The problem is far from solved, however, and some real estate loans could become
nonperforming if Chinas real estate boom cools. Moreover, the banks are still majority
owned by the state, and the release of shares may have been slower than necessary.
Nevertheless, considerable progress has been made in moving Chinas banking system in
a direction where bank loans can be made on the basis of sound economic principles
rather than by government fiat.
Table 1
NON-PERFORMING LOANS TO TOTAL LOANS OF
THE BIG FOUR CHINESE BANKS
2001 2002 2003 2004 2005 2006
Agricultural Bankof China
41.4 36.7 30.7 26.7 26.2 23.4
Industrial and CommercialBank of China
29.8 25.5 24.2 21.2 4.7 3.8
Bank of China 19.4 15.4 16.3 5.1 4.6 4.0
China Construction BankNA 17.0 4.3 3.9 3.8 3.3
Source: Annual Reports
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The Role of the Stock Market in a Market Economy
The allocation of capital resources plays a critical role in any economys ability to
sustain real economic growth. If capital is not made available to those enterprises and
industries capable of increasing both productivity and production, the economic growth
rate will suffer. The flexibility and speed of the capital allocation process is essential to
ensure the adaptability of the economys productive process and thus its long-run rate of
growth.
Stock markets can offer important signals to corporate management about the cost
of investment capital, which is vital to ensuring that an optimal amount of real investment
in plant and equipment is undertaken. During Chinas Mao years from 1949 through
1977, there were no stock markets and the country was almost completely at the planned
end of the economic spectrum. State-owned enterprises (SOEs) accounted for more than
97 percent of GDP. These enterprises were not disciplined by the profit motive, and they
invested in large numbers of non-productive projects.
With the institution of economic reforms under Deng Xiaoping, China came to
recognize that a stock market could play an important role in the restructuring of its
hopelessly inefficient SOEs. The countrys new leaders understood the principle that the
privatization of the SOEs through stock ownership could provide both the financial
discipline and the hard constraints that force managers to act in the interest of
shareholders rather than in the interest of the state or the managers themselves. In this
way, a stock market can help to improve corporate governance. At its best, it can help to
correct the poor management, lack of accountability, and widespread corruption
associated with many of the SOEs.
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Efficiently functioning stock markets also offer easy-to-understand evaluations of
the financial conditions of individual companies as well as their future prospects. Finally,
stock markets perform what William J. Baumol has called an act of magic by
permitting long-term investments to be financed by funds from individual savers who
may tend to hold those investments for only limited periods of time. In the case of China,
stock markets are particularly important since they offer investment outlets for the
substantial amounts of individual savings as well as for Chinese institutional investors.
This provision of liquidity tends to lower the cost of capital funds and facilitates the low-
cost financing of long-term investments. As Baumol concludes in his book The Stock
Market and Economic Efficiency (1965), one is readily inclined toward the view that the
stock market constitutes an allocative mechanism of remarkable efficiency. How
effectively the Chinese stock market fulfills these expectations of efficiency is the subject
to which we turn next.
The Efficiency of the Local Chinese Stock Markets
While the stock market has the potential to be an effective allocator of capital, it
will do the job well only if it is reasonably efficient. By efficient we mean that stocks
can be bought and sold in reasonable volume at prices that roughly reflect their intrinsic
values. Eugene Fama (1970) has argued that efficient stock markets accurately reflect all
available information at all times. He also distinguished different types of efficiency
depending upon the information set considered. Weak-form efficiency implies that
current prices reflect all historical price information. In a weak-form efficient market
prices will adjust to news without delay and therefore no excess returns can be earned by
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studying the past pattern of price changes. Weak-form efficiency is often associated with
the random-walk hypothesis, where future price changes are independent of price
changes in the past. If new information is only slowly reflected in stock prices, however,
then we would expect stocks to move in the same direction for periods of time. Thus, in
an inefficient market, various chart patterns may enable traders to earn excess returns.
Moreover, there will generally be strong evidence of momentum in share prices, and
various anomalies such as seasonal and day-of-the week effects may be present.
Fama also considered tests of stronger forms of efficiency where the information
sets to be reflected in share prices included all the public and private information about
earnings, book values, investment opportunities, etc. In the semi-strong form of the
theory, all public information would be fully reflected in market prices. In the strongest
form of the theory, even private (insider) information would already be incorporated into
market prices. In a strong or semi-strong form efficient market, professional security
analysts and portfolio managers would not be able to outperform a simple index fund that
bought and held a broad index, including all the stocks traded in the market.
Weak-Form Efficiency of the Chinese Stock Markets
A substantial number of studies have attempted to determine the extent to which
the Chinese stock market is weak-form efficient.1 It is difficult to draw definitive
conclusions from this work for several reasons. First, many of the studies were
performed using data from the pre-2006 period, when the total capitalization of the
Chinese markets was very small. Much more time will be needed to assess how the
1See Groenewold et. al (2004), Ma (2004), Zheng (2006) and Massey (2007).
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substantial increase in both market capitalization and trading volume has affected the
efficiency of the market. Second, as noted above, there are several types of Chinese
shares, and there is reason to believe that the efficiency of markets open to the
international investing community such as the H-share market will behave differently
from the A-share market that is largely restricted to local residents. Finally, the results of
some studies are conflicting, and in other analyses the results were somewhat ambiguous.
Despite these difficulties, I think it is possible to draw some tentative conclusions.
The A-share market does not appear to be weak-form efficient. In many tests the
random-walk hypothesis is strongly rejected, and a large number of non-parametric tests
also suggest inefficiency. Most studies have found particularly strong seasonal and day-
ofthe-week patterns, and in some analyses it appeared that traders could fashion trading
techniques that could outperform a buy-and-hold investment strategy. Statistical findings
of weak-form efficiency are buttressed by numerous anecdotal examples of stock price
manipulation through wash sales and other manipulative techniques.2
There is also evidence that the H-share market has not been efficient in the past,
especially earlier in the 1990s and during the SARS epidemic in 2003. Students of mine
have found using more recent price data, however, that the H-share market has become
more weak-form efficient over time.3
Broad-Form Efficiency of the Chinese Stock Market
As indicated above, the semi-strong and strong forms of the efficient market
hypothesis broaden the types of information that should be reflected in stock prices to
2 See, for example Wu (2004).3 See Zeng (2006) and Massey (2007)
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include fundamental information about the economy and about individual companies.
For semi-strong efficiency, stock prices should reflect all public information. Strong-
form efficiency requires that even private information should be reflected in stock prices.
Hence not even professional investors or insiders would be able to earn excess risk-
adjusted returns.
We will examine three kinds of evidence in assessing the degree to which the
Chinese stock markets are broad-form efficient. First, we will examine event studies that
test whether important news announcements become incorporated into stock prices
without delay. As a second test, we will examine the prices of stocks that are multiply
listed on the Shanghai stock exchange as well as in Hong Kong and in New York. We
will determine whether The Law of One Price is violated. Finally, we will examine
some of the simplest, yet, in my judgment, the most convincing evidence of efficiency or
lack thereof. Do professional investors tend to outperform broad-based index funds?
The more inefficient the market, the more likely it is that professional investors,
especially those with useful connections, will earn higher risk-adjusted returns than
index-fund investors.
A) Event Studies
Studies have been conducted of the reaction of Chinese stock prices to various
important news announcements such as dividend increases or cuts and bonus and rights
issues. In an efficient market we should see stock prices react immediately and fully to
the news announcement. In an inefficient market we would observe abnormal returns
following the announcement, indicating an incomplete adjustment to news. While there
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appears to be different reactions to different types of news, the predominant finding is
one of incomplete and inefficient adjustment, Ma (2004) concludes that event studies
indicate that Chinas stock market is not semi-strong efficient.
B) Violations of the Law of One Price
Another method of evaluating the efficiency of markets is to examine whether
stocks traded in different markets sell at the same price4. For example, the price of BP
PLC stock traded on the London Stock Exchange should be the same as the price of the
BP shares traded on the New York Stock Exchange. Any discrepancy would be
corrected by arbitrage, and indeed the Law of One Price is validated in the New York and
London markets.
The Law of One Price is violated, however, in the A-Share Chinese market.
Table 2 shows the closing prices for a share of Sinopec, the large Chinese chemical and
petroleum company, on January 18, 2007 in Shanghai, Hong Kong, and New York. The
closing prices in Hong Kong and New York are not identical, but they represent trades 13
hours apart in time. Since arbitrage is possible, substantial discrepancies would be
corrected. But the prices in Shanghai and Hong Kong (which are in equivalent time
zones) are substantially different. Nor is this aberration a one-day phenomenon. Exhibit
4 shows that large and variable discrepancies were observed throughout the first half of
2007. Such differences remain because currency and other restrictions prevent profitable
arbitrage from taking place. If these restrictions are eliminated in the future, such
anomalies are unlikely to be sustained.
4 See, For example, Lamont and Thaler (2003 )
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Table 2
Violation of the Law of One Price
Data for January 18, 2007
Adjusted into U.S. Dollars
Price in Shanghai Price in Hong Kong Price in New York
China Life $83.91 $46.97 $47.69
Sinopec $118.40 $81.71 $80.92
Exhibit 4
C) Professional Investors vs. Market Indexes
In an efficient market stock prices reflect unbiased estimates of the intrinsic
values of the securities traded. In such a market professional investors are unlikely to
outperform a market index before costs and will tend to underperform the market after
The A Share Premium December 2006 June 2007 Sinopec(Sinopec shares price premium on Shanghai Stock Exchange versus New York Stock Exchange)
0
20
40
60
80
100
Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07
%P
remium
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investment costs. Studies by Jensen (1969) and Malkiel (1995) suggest that in the
reasonably efficient United States stock market, professionally managed mutual funds
tend to underperform broad-based index funds after expenses. In China, however,
professional mutual fund managers substantially outperform market indexes even after
expenses.
An examination of the investment results of all equity fund managers in China is
shown in Table 3. Because funds operate under a variety of restrictions, including the
proportion of the fund that can be invested in equities, only the equity portion of the fund
returns were included in the analysis. All open and closed end fund manager results were
included. As the table shows, from the period 1998 through 2006, managed fund
investments in equities substantially outperformed both the Shanghai and Shenzhen stock
indexes. While it was not possible to adjust the results for risk, it is highly likely that the
risk-adjusted differential would have been even greater. Managed funds tend to hold
larger investment grade stocks in their portfolios rather than the more speculative smaller
issues.
Several tests of broad-form efficiency lead to the same conclusion. The A-share
market for the equities of Chinese companies does not appear to be efficient.
Active Management vs. Indexing in the H-Share Market
Data are readily available to test whether active managers of funds investing in H
shares are able to outperform an H-share index. There is a well known and investable
index of Chinese company H shares called the FTSE/Xinhua 25 Stock Index; an active
exchange-traded fund that tracks the index trades on the New York Stock Exchange
under ticker symbol FXI. We can examine the records of mutual funds domiciled in the
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Table 3
Managed Equity Funds in China Compared with Local A-Share Indexes
1998 2006 Return ofManagedFunds*
(%)
Return ofShanghai Stock
Index**(%)
Return ofShenzhen Stock
Index**(%)
Average AnnualReturn
20.75 16.20 16.20
* Return is measured by the return of the equity portion of the managedfund portfolio. Included in the calculation are the returns from all open-and closed-end funds that are restricted to buying local shares.
**These differences of over 450 basis points may be overstated by as muchas 150 basis points since the returns from the indexes measure only pricechanges while the returns from the managed funds are total returnsincluding dividend payments.
SOURCE: Bosera Asset Management Co.
United States as well as those domiciled in Hong Kong. Data are available for U.S.
managers from 2001 through June 30, 2007. Data are only available for Hong Kong
domiciled equity funds for a shorter period. Both groups were tested to ascertain whether
the local managers were able to achieve different results from the foreign managers.
Since most U.S. managers spend considerable amounts of time in China, however, there
may be little difference in the results of the two groups.
Exhibit 5 presents the performance of all the mutual funds in the United States
that invest in Chinese companies available to international investors. Only two of the
actively-managed funds outperformed the FXI Exchange traded fund (ETF).5 Most
5 Both the FXI ETF and the managed-fund returns were measured after management expenses. Themanagement expense of the ETF was substantially below the expense for the actively-managed funds.
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actively-managed U.S. mutual funds underperformed FXI during the period from 2001
through June 2007
Exhibit 5Excess Return
Actively Managed US China Mutual funds Compared with FXI Index
2001 - 2007
0
1
2
3
4
5
6
7
-8 to -6 -6 to -4 -4 to -2 -2 to 0 0 to 2 2 to 4
NumberofFunds
Funds Underperforming Funds Outperforming
We can also examine the risk-adjusted performance of U.S. China mutual funds
by calculating each funds Sharpe Ratio and comparing the results with the Sharpe Ratio
for the FXI index. This is done in Exhibit 6. The Sharpe Ratio for the FXI index was
approximately 1.1 during the period of the study. Again, only two U.S. mutual funds had
higher ratios, indicating superior risk-adjusted performance. Most of the funds had
Sharpe Ratios lower than that of the index.
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Exhibit 6
Exhibit 7 presents the results for the Hong Kong mutual funds. Again we see that
the active-managers are not able to outperform the FXI exchange-traded index fund,
either before or after management fees. It appears that the prices of H shares are more
closely related to the intrinsic value of the shares and that the H-share market is more
efficient than the A-share market. We attribute the difference to two factors. First, the
shares listed in Hong Kong have more stringent disclosure requirements and fully
conform to international accounting standards. In addition, there is a strong presence of
Better Risk Adjusted Returns
0.8-0.9 0.9-1.0 1.0-1.1 1.1-1.2 1.2-1.3 1.3-1.4 1.4-1.5 1.5-1.SharpeRatio of
FXI Index
Number ofFunds
Poorer Risk Adjusted Returns
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sophisticated institutional investors in the Hong Kong market. The A-share market has
yet to develop a strong institutional presence, and prices are likely to be more susceptible
to the whims of individual investors.
Exhibit 7
In summary, it appears that the Chinese A-share market is neither narrow-form
nor broad-form efficient. It is also an extraordinarily volatile market even when
compared with other volatile emerging markets such as Brazil. It would be difficult then
to conclude that the local market can be relied upon to give proper signals to corporations
to ensure an efficient allocation of capital. Despite the growth in the markets total
capitalization and its emergence as an important source of equity finance, China still has
far to go to satisfy the Baumol criterion for the stock market to be a capital allocator par
excellence.
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But China does have on its shores a market in Hong Kong that appears to be
reasonably efficient. Hong Kong also is home to banking institutions that are free from
government control. As China continues its remarkable transformation, are there steps
the government can take now that will make better use of market incentives? I believe
that the answer is yes. The last section of this paper turns to the logical next steps that
will help China to continue to grow and prosper.
Some Useful Next Steps for the Chinese Economy
China has clearly made considerable progress in strengthening its financial system
during the 2005 2007 period. But there is also substantial unfinished business on the
road to financial reform. Here I will outline a few suggestions that would help hasten
Chinas transformation and facilitate its future growth.
Most Chinese firms are still majority owned by the state. As long as this remains
the case, there will be severe governance problems. The state has little or no interest in
the price of the shares and thus in taking actions that benefit the private shareholders.
The non-performing loan problem is one manifestation of this arrangement. The state
may want to keep essentially bankrupt state-owned enterprises alive through loans,
especially companies that employ numerous workers, even though the private
shareholders of the bank would prefer that such loans not be made. Governance reform
and a reduction in agency problems will never be successful until the majority of the
outstanding shares are in the hands of non-government shareholders. Moreover, limited
float makes price manipulation more feasible. The privatization of state-owned
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companies and banks is an urgent imperative that will benefit the Chinese economy and
facilitate its ability to continue its rapid growth.
China has moved to make the previously non-tradable government-owned shares
tradable on the stock exchanges. By the start of 2007, all companies on the Chinese stock
markets had either announced or had already completed a program to make their
restricted shares tradable. But making the shares tradable and actually releasing the
shares to private ownership are two different things. While the government has sold
some shares through public offerings, most of the shares of Chinese companies
(including financial institutions) are still in the hands of the government and only limited
amounts will be sold to the public over time. A more rapid release of the shares would
not only speed up the reform process, but also could cool off the rampant speculation in
the market. The A-share markets rose by 130 percent in 2006 and by September 2007
share prices had doubled again. Turnover in the market was approximately 75 percent
per month in the summer of 2007. A bubble in stock prices that later bursts is certainly
not in the interest of sustaining economic growth.
The full privatization of Chinas banks and corporations can not be undertaken
independently of China making more progress in closing down the money losing and
highly inefficient state-owned enterprises (SOEs). Some SOEs have been successfully
reformed but others are truly zombie enterprises that will require continued infusions of
cash. China then faces a delicate balancing act. China must continue to encourage the
vibrant private sector of the economy while cushioning the fallout from the gradual
closing of the most inefficient of the SOEs.
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There is much more that needs to be done to make the Chinese stock markets
more rational. Functioning financial markets require objective and independent
accounting. It is widely believed that Chinese firms traditionally carried four sets of
books one for the government, one for official company records, one for foreigners, and
one (obviously not widely available) for what was actually going on.
As of January 1, 2007, Chinas Ministry of Finance now requires all companies
listed on the Shanghai and Shenzhen stock exchanges to report their annual performance
in terms of International Financial Reporting Standards (IFRS). This is an enormously
ambitious project, since many Chinese companies consist of numerous subsidiaries, and
there is a woeful lack of qualified accountants to process and clarify the raw numbers.
(The Chinese accounting profession is still recovering from having been sent, lock, stock,
and barrel, to the countryside to be reeducated during the Mao years.) To give some idea
of the task facing the listed companies, it has typically taken three years for expectant
Chinese corporations to meet the listing requirements consistent with the IFRS and
mandated by the Hong Kong Stock Exchange. While progress has been slow, the new
requirement is clearly a step in the right direction.
China also needs to relax the cumbersome restrictions that have kept the Chinese
A-share market separated from world financial markets. To be sure, some very small
steps have been taken. The Qualified Foreign Investor Program (QFII), begun in
November 2002, permits a limited number of qualified institutional investors, on an
annual renewal basis, to participate directly in Chinas domestic stock markets. Although
the quotas have been expanded over time, they are still relatively small. Moreover, there
are limits to the number of A shares that QFIIs may acquire in any single company, and
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the program does not permit the unrestricted repatriation of the funds. The regulatory
authorities were worried that since the total capitalization of the domestic market was
very small, it would be overwhelmed if foreign investors were given full access. That
argument is not tenable now. A vastly liberalized QFII program could bring a much-
needed international institutional presence to the market and could help in eliminating
some of the anomalies in the A-share market.
In July 2006, the government introduced the Qualified Domestic Institutional
Investing (QDII) program. Similar to the QFII program, it allowed local institutions to
exchange limited amounts of Yuan into foreign currencies in order to buy shares on
international exchanges. In August of 2007 the government announced further steps
called a trial effort to make it easier for Chinese citizens to invest in the Hong Kong
market. It is not yet clear how this plan will be implemented. Until Chinese citizens can
easily and freely exchange their currency for Hong Kong dollars without limit (and vice
versa), the A-share market is likely to remain inefficient. Perhaps an even more
important advantage for the Chinese is the effect on the exchange rate. Allowing their
citizens freedom to buy foreign currencies, would tend to limit the appreciation of the
Yuan and help keep Chinese exports highly competitive in the world markets. Financial
economists in Asia are rightly concerned that a repeat of the Asian financial crisis of the
late 1990s would be devastating for China. But with China holding almost one and one-
half trillion dollars of reserves and with a currency that is extremely attractive on a
purchasing power basis, fears that loosening restrictions on currency movements will lead
to a run against the Yuan seem highly unrealistic.
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Concluding Comments
China has come a long way transforming its economy from one almost
completely controlled by the state to an economy where market incentives increasingly
control the patterns of investment, production, and consumption. But a maze of financial
market restrictions remain that will, I believe, interfere with an efficient allocation of
future investment resources. This paper has suggested a number of reforms that represent
unfinished business on the road to full economic transformation.
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